The World Bank
FPD Note No. 38
March 1995
Private Sector Development Department
Vice Presidency for Finance and Private Sector Development
Bankruptcy’s Role in Enterprise Restructuring:
A Hammer to Turn a Screw?
S. Ramachandran
State-owned enterprise restructuring in the trans-
forming economies of Eastern Europe and the
former Soviet Union has been slower than many had
hoped. Some have blamed the slow pace on the
absence or inadequacy of bankruptcy laws and pro-
cedures—and have advocated introducing bankrupt-
cy law modeled on the best laws in Europe and the
United States. And when that fails to accelerate en-
terprise restructuring, they call for more judges and
training or for mandatory out-of-court settlements.
These prescriptions are contradictory and may be
based on faulty diagnosis.
Bankruptcy laws and procedures are not needed for
the immediate problems in transforming economies:
separating good firms from bad (for which cash or
“hard budget” constraints suffice), liquidating value-
subtracting firms, and financing potential value-
adding investments. Indeed, the problem for which
bankruptcy law is most needed—preserving going
concern values when there are multiple claimants—
may be several years away for most transforming
economies. Furthermore, resource allocation is not
materially affected by the choice of bankruptcy laws
and procedures as long as the free-rider problem
associated with multiple claimants in the same class
is handled effectively (for example, through cram-
down rules). While courts must approve agreements
in bankruptcy cases if the agreements are to be bind-
ing, such “rubber stamping,” done correctly, should
not delay enterprise restructuring. A large backlog of
bankruptcy cases is less likely to mean that bankrupt-
cy courts or procedures are ineffective than that dis-
puting parties have filed petitions to preserve their
claims (or their position in the claimant queue) or as
a negotiating tactic—or that claimants (usually the
state as creditor or tax collector) lack the incentive to